This tax code distortion makes the financial system and the
economy more fragile and prone to bankruptcies and runs. Banks
profit, and the economy teeters.
Thanks to a leaked video, we know that Mitt Romney, the
Republican presidential candidate, divides the United States into
those who pay income taxes and those who do not, the makers and the
moochers.
There is one perhaps surprising group you can put in the latter
category: banks. Sure, banks pay taxes, but they pay a lot less,
thanks to a giant and underappreciated distortion in the U.S. tax
code. Moreover, this tax code distortion makes the financial system
and the economy more fragile and prone to bankruptcies and runs.
Banks profit, and the economy teeters. Great bargain, huh?
It is the tax code's favoring of debt over equity.
For businesses, debt interest payments are tax deductible; equity
payments, like a company's payment of a dividend, are not. At the
margin, this encourages entities to take on more debt than they
otherwise would. More debt not only makes companies more vulnerable
to bankruptcy, it also makes investors more susceptible to panics,
in which they withdraw their capital en masse. More equity would
make the world more stable.
"The worst thing the tax code can do," said Victor Fleischer, a
tax specialist at the University of Colorado, "is to make it harder
to use a sensible capital structure." Mr. Fleischer, a contributor
to The New York Times DealBook, testified to Congress last year
about this problem.
This distortion is well known. President Barack Obama, in his tax
overhaul proposal, mentioned it, though he did not make any specific
proposal about what to do about it. The Republican presidential
candidate, Mitt Romney, is proposing substantial tax cuts with the
loss of revenue made up through the closing of loopholes. He has yet
to specify any of those loopholes, but corporate debt interest
deductibility has not been in the conversation.
What is not well appreciated is how much the debt deduction helps
the banks. The first way is direct: Banking is a highly leveraged
industry. Banks use more debt than equity to finance their
activities. The tax break makes the debt less costly and encourages
banks, at the margin, to gorge on more.
Financing techniques that have become more popular in recent
decades benefit from this distortion. Bundling of debt, like credit
card receivables or mortgage debt, called securitization, turns out
to give banks a tax bonanza. For accounting purposes, banks are
typically able to treat their bundling of this debt as a sale. But
for tax purposes, banks often get to call it debt. Those payments to
the buyers of the securitizations' bonds are therefore tax
deductible for the bank.
More important, there is an indirect and unremarked benefit.
Banks help companies raise money in two main ways: through the sale
of stock (equity) and debt, either through loans or the sale of
bonds. When a company goes public, selling stock for the first time,
the underwriting banks make more money than they do for a comparable
debt offering. But banks make it up on volume with debt. Bonds
expire. Companies issue more of them all the time.
Partly because of the tax code distortion, corporate debt is
underpriced and overconsumed by the bank's corporate customers.
Indeed, the debt business dominates the world of investment banking
these days. When corporations raise more debt, compared with equity,
that fattens bank profits.
Then, too, the trading of debt is more profitable than the
trading of equity. Stocks are traded on transparent markets at
transparent prices. Debt is traded in opaque ways, where the spread
between the offered and requested prices is wider than for stocks.
That means more profit for investment banks than for stocks, whose
trading spreads have narrowed for decades. So, too, with derivatives
and securities based on debt -- things like collateralized debt
obligations.
And these complex debt securities give society what? The U.S.
system subsidizes the middleman to create dubious products. Those
products help the middlemen -- the banks -- but they make the
financial system more fragile. So the tax code distortion does not
just lead to more debt in corporate America and more-leveraged
banks. It also helps create a finance-heavy economy in which the
banking sector accounts for a bigger proportion of gross domestic
product and corporate profits than it otherwise would. Granted, the
tax code is far from the only force in U.S. society that creates a
larger financial sector or overleveraged corporations. But it's one
of the least recognized.
As many of us have come to understand since the financial crisis,
having a bigger finance industry than necessary wastes resources.
Banking is supposed to provide capital to help companies create real
goods and services, not be an end unto itself.
As it is, lawyers, accountants and investment bankers spend
thousands of billable hours analyzing transactions to figure out
whether there are ways to treat them like debt, rather than equity.
Are there solutions to this distortion?
There are two choices: reduce or eliminate interest deductibility
or introduce some deduction for equity.
Neither seems particularly feasible for some time. Reducing the
deductibility would be elegant, but it would generate screams of
bloody murder from corporate America.
Making dividend payments tax deductible, which would start to
level the playing field, might be easier and more popular. Of
course, that would reduce revenue to the government and have to be
made up somehow, through tax increases elsewhere or decreased
services.
Mr. Fleischer suggests that one way to limit the distortion would
be to eliminate the deduction to the extent a financial institution
exceeds a ratio of debt-to-equity of 5 to 1. If a bank has borrowed
$6 for every $1 in stock, then it would not get to deduct the
interest payments on that extra dollar of debt. That would make debt
more expensive and make banks less inclined to borrow as much.
And it would help stop banks from being moochers.
